Q: When the inheritor of a Roth IRA receives the funds, is it true that the distributions would not be taxed?
A.: Most of the time, yes. It would be unusual for any taxes to be due on an RMD from an inherited Roth IRA. The only portion of an inherited IRA that could be subject to tax is earnings. All other portions of a Roth IRA have been taxed in the past.
In order for those earnings to be taxable, they would have to be distributed within the five-year period beginning with the tax year for which the first monies went into the deceased’s very first Roth IRA.
If a Roth IRA owner dies in 2020 and they opened their first Roth IRA for tax year 2015 or earlier, every penny is available tax-free to their beneficiary. This is true even if that original Roth IRA account no longer exists and even if the contribution for 2015 was deposited in 2016. (IRAs and Roth IRAs can be funded for a tax year as late as the April tax filing deadline.)
If the deceased opened their first Roth IRA in 2016, 2017, 2018, 2019 or 2020, earnings would be taxable if distributed before the applicable five-year period is up. Again, this rule applies to very first Roth IRA the deceased owned. So, if they opened their first Roth IRA for 2017, the entire account is available tax-free starting in 2022. If the first Roth was funded for 2019, the beneficiaries must wait until 2024 to get earnings tax-free.
That does not mean they can’t get any funds tax-free before the five-year period is up. All the other funds that are not earnings are available tax-free. The so-called ordering rules dictate that these non-earnings amounts come out first. These funds that are available immediately tax-free to a Roth IRA beneficiary are the amounts contributed over the years or converted from traditional IRAs. The five-year rule that applies to conversions does not apply after the Roth IRA owner dies because the 10% penalty ordinarily imposed when taxable amounts are distributed from IRAs or Roth IRAs to someone under age 59½ does not apply to beneficiaries of such accounts regardless of the ages involved.
There is another factor that mitigates the chance that earnings would be taxable, the Required Minimum Distribution rules. For persons dying in 2019 or earlier, many beneficiaries opt only take out the Required Minimum Distributions (RMD) each year. Those RMD are usually a relatively small percentage of the Roth IRA account. Since already taxed funds like contributions and conversion come out first and earnings come out last, in most cases the RMD will be too small to cause earnings to be distributed before the five-year requirement is satisfied.
For a Roth IRA owner passing in 2020 or later, there is no annual RMD for most beneficiaries. Instead they must empty the inherited Roth IRA by the end of the 10th year after the Roth owner’s death and therefore should be able to satisfy the five-year rule.
Lastly, if the first Roth IRA was opened less than five years ago, there may not be a lot of earnings to worry about. That is not always the case of course, but if it is and a beneficiary needs the funds, paying some tax on the small amount of earnings may be palatable especially since no 10% penalty applies.
If you have a question for Dan, please email him with ‘MarketWatch Q&A’ on the subject line.
Dan Moisand is a financial planner at Moisand Fitzgerald Tamayo in Orlando, Melbourne, and Tampa Florida. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.
